Taking Profit As A Stock Goes Up, Down Or Sideways

by: Option Premium

Before I tell you how I trade, let me tell you how I don't trade.

  • I don't chase breakouts
  • I don't trade swings
  • I don't gamble on earnings (except for the occasional "lotto ticket")
  • I don't call tops or bottoms

To be successful in any of these types of trades, not only do you need to pick the stock correctly, but you also have to get the direction of movement right. Your trade execution also needs to be pretty solid. It also helps to have the market winds at your back. Should any of those four factors be off, you could quickly end up with a losing trade.

Combine this with having to get the time frame correct for option trades (remember theta is always working against you when you're long options), and you've got a formula that I have yet to solve. Plenty of other people can, but I'm not one of them.

This led me to the idea of income investing. That is, holding stocks for dividends, selling covered calls, and selling options in general.

Dividend investing was too passive for me. Selling covered calls and cash-secured puts on those dividend stocks was a step up, but the returns were not spectacular, and the strategies were still subject to daily/weekly market fluctuations.

Instead of trying to guess where a stock will go, and when it will go there, I focus on where a stock will not go.

I do this (mostly) by selling what are known as vertical spreads. These can be traded with a bearish or bullish direction. For a bullish trade, I will sell (short) an out-of-the-money (OTM) put, and buy (LONG) a further OTM put, usually one strike further OTM. You receive the premium for selling the put minus the cost of buying the put. Since the put you sell is nearer to being ATM, the net trade is a credit to your account.

For a bearish trade, I would sell (short) an OTM call, and buy a further OTM call. This is also for a credit.

I said that they can be traded either direction, but (part of) the beauty in selling verticals is that the stock can actually move against you and you will still profit. As long as the price of the underlying doesn't end up below the short strike at that month's option expiration date (opex), you keep all of the premium. In fact, it can end up between the price of the two strikes and you may still break even, you may just have to pay back part of the credit. Also note, that the stock can cross the short strike at any time prior to expiration, but if it closes above the short strike on opex, you still keep all of the premium.

Now, due to the time decay of options (known as theta), as each day passes, ignoring any price movement in the underlying, the options will lose value. Hence, the spread itself will lose value. This means should you decide to buy it back prior to opex, you will buy it for less than you sold it, making a profit. This is the theory behind the previous paragraph. Eventually, the value of both options erodes to zero, as long as they are OTM.

One other point I like is that by buying the further OTM option, you limit your downside risk to the difference of the two strikes, minus the total credit received. Compare this to selling a put by itself (going naked) where the risk is unlimited.

Here's an example:

On 3/8 (the vertical blue line) with Priceline.com (PCLN) trading around 650, I sold the Apr 12 580/570 bull put spread. I sold the April 2012 580 put for $5.25 and bought the April 2012 570 put for $4.15. Thus, I received $5.25-$4.15 = $1.10 x 100 = $110 for each spread I sold.

PCLN had just gapped up two weeks prior due to a strong Q1 earnings report. It had tested the top of the gap (the short blue line) but never closed the gap. I was using this line for support, as well as the longer blue line below it. As long as the stock didn't close below this longer blue line on April 2012 opex (4/21/12), I kept the entire $110.

Not too bad huh? It certainly isn't for everyone, but it works for me.

Momo stocks like Apple (NASDAQ:AAPL), Chipotle (NYSE:CMG), Salesforce (NYSE:CRM), F5 Networks (NASDAQ:FFIV), Google (NASDAQ:GOOG), Mastercard (NYSE:MA), VMware (NYSE:VMW), and plenty others tend to be great for this strategy due to their usually high premiums. One thing to avoid though is selling spreads on stocks reporting earnings prior to the spread's expiration date. That's pure gambling.

You can do this on a month-to-month basis, without having to be glued to the screen to watch each tick of the stock. They also work well to hedge a covered call or diagonal LEAP you may have on. I'll get to these in another article.

I'll leave you with one last thought:

Pick a stock right now, any stock. I bet you that tomorrow the price of that stock is going to go up... or down. Wouldn't you feel comfortable knowing you'll still have the potential to make money either way?

Disclosure: I am long AAPL, CMG, FFIV, GOOG, MA, PCLN, VMW via credit put spreads.